The difference between an interest rate and an annual percentage yield relates to how the interest rate is measured. Understanding each one can help you gauge the advantages and disadvantages of certain specific financial instruments. It is best to know both the interest rate and the APY before making a decision.
Interest rate can also be referred to as annual percentage rate, or APR. It refers to the rate at which interest will be applied to the account on a yearly basis. APR is most often used to measure the interest rates on mortgages and investments.
Annual percentage yield, or APY, is stated as an interest rate just like the APR, but it includes compound interest. This offers a more precise measure of how the interest will accumulate over time. Basically, compound interest refers to interest paid not only on the principal but on the previous months' interest, too. If you have money in a savings account, this means that you earn interest on your balance this month, and next month you'll earn interest on that interest as long as you have not withdrawn it. On a credit card, you're charged interest each month, and if you roll over your balance and don't pay it off, you'll end up owing even more interest next month because you're also paying interest on the interest that was added previously.
It is best to understand the APY on credit cards and other bank loans because it gives a very close estimation of how much interest will be paid on the account.
There are two types of APR that can be used when marketing financial instruments. The nominal APR is the interest that will be paid for a certain amount of time, such as for a month, multiplied by the number of payments that will be made within a year. This type of APR is a vague estimate and can understate the actual cost. The effective APR includes the compound interest rate as well as any additional fees that will be charged to the account. This type of APR is more accurate but isn’t used as frequently.
Therefore, the effective APR and the APY are closely related, but the APY only includes compound interest and doesn’t include any additional fees that may be charged to the account.